SEARCH, INDEX, UPDATES, CONTENTS, UNDERSTANDING, BASIC ACCOUNTS, P&L ACCOUNT, GROSS PROFIT
A business makes a profit when it sells goods, not when it buys them. A purchase of goods at a very competitive price increases the potential to make a profit, but it does not make a penny of profit until those goods are sold.
It is for the above reason that Stock (and Work In Progress) should always be valued at cost. Cost will exclude VAT for a VAT Registered business, but include VAT for a VAT exempt business.
The concept of Gross Profit is best understood with a simple example.
| Period 2 | Period 1 | |||
| Sales | 337 | 0 | ||
| Opening Stock | 100 | 0 | ||
| Purchase | 200 | 100 | ||
| Subtotal | 300 | 100 | ||
| Closing Stock | 75 | 100 | ||
| Cost of Sales | 225 | 0 | ||
| Gross Profit |
33% |
112 | 0 |
In Period 1 some goods are purchased, but none are sold, so the goods are carried forward at their cost price.
In Period 2 some more goods are purchased, and added to the goods already in stock. Three quarters of the total goods are sold. This leaves £75 as the cost of goods still in stock and gives £225 as the cost of the goods sold.
With sales of £337 costing £225, the Gross Profit is £112. £112 as a percentage of £337 sales is 33%.
Before selling the goods the proprietor will have decided his selling price by adding a Mark Up percentage. In this example the Mark Up percentage is 50%.
50% Mark Up on purchases gives 33% Gross Profit on sales and accountants often find clients talking about Mark Up when the accountant is talking about Gross Profit. This can lead to expensive misunderstandings so please try to be clear about the term being used.
This Gross Profit Percentage is often shown in accounts and is certainly of interest to the Inspector of Taxes.
Because a business normally sets an average Mark Up, an Inspector of Taxes will calculate the expected Gross Profit and then see how that compares to the percentage reported in the accounts. It will differ because of stock pilfering, sales promotions and discounts, and the Inspector will have to make allowances for these. If there is still a significant variation, the Inspector will want a good explanation !
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